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Intrinsic Value

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life.

It is not a simple value to calculate and must be estimated. This estimate will also depend on the interest rates and any forecasts of future cash flows. That is why Warren Buffett never gives an estimate of their own intrinsic value.

What is regularly reported is their per-share book value, which can be easily calculated but is of less use. This is because the book value of the companies that Berkshire controls may be far different from their intrinsic value.

For example in 1964, Berkshire’s per-share book value was $19.46. This far exceeded the company’s intrinsic value as all of the company’s resources were tied up in a non-performing textile business.

Now, the situation is reversed and Berkshire’s book value far understates their intrinsic value.

Nevertheless, the book value is still reported as it serves as a rough tracking measure for the intrinsic value. In any year, the percentage change in book value is reasonably close to that year’s change in intrinsic value.

As an analogy, consider a college educaion and think of the education’s cost as “book value”. The intrinsic value of the education is calculated by estimating the earnings of the graduate over his lifetime and subtracting from that figure an estimate of what he would have earned had he lacked his education. The final figure is then discounted back to present day figures using an appropriate interest rate.

Some graduates mya find that their book value of their education exceeds its intrinsic value and some may find otherwise. Whatever the case, it is clear that book value is meaningless as an indicator of intrinsic value.

On The Managing of Berkshire after Buffett’s Death

Warren and Charlie attend mainly to the task of capital allocation and leave all the running to the managers of the subsidiaries. Out of Berkshire’s 217,000 employees, only 19 of them are at headquarters.

The managers have total control over operating decisions and will dispatch any excess cash they generate to headquarters.

On Buffett’s death, none of his shares will have to be sold. They will be left to foundations who will receive them in installments over a dozen or so years.

The Buffett family will not be involved in managing the business but will help to pick and oversee the managers who do. Essentially, Warren Buffett’s job will be spilt into two parts. One executive who will be responsible for investments, and a CEO who will be in charge of operations. Any acquisition decisions will be mabe by the two with the approval of the board. These people have already been identified.

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Owner’s Manual – Part 1

In June 1996, Warren Buffett issued a booklet called “An Owner’s Manual” to Berkshire shareholders. If you like to read the entire 5-page manual, you can download an updated version of it at the Berkshire Hathaway website.

Here’s a summary of the things that are covered in the manual.

13 Owner-Related Business Principles

1) Shareholders are treated as owner-partners, with Warren and Charlie Munger taking the role of managing partners.

2) Most of Berkshire’s directors have a major portion of their networth invested in the company.

3) The long term economic goal is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.

4) The preference to reach this goal is to directly own a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, obtained through purchases of marketable common stocks by Berkshire’s insurance subsidiaries. The challenge for Berkshire is to generate ideas as rapidly as they generate cash.

5) Because of the two-pronged approach to business ownership, consolidated reported earnings will reveal very little about their true economic performance.

6) Accounting consequence do not influence operating or capital-allocaton decisions.

7) Debt is used sparingly and when it is used, preference will be to structure it on a long-term fixed rate basis. Interesting opportunities will be rejected if there is a need to over-leverage.

8) A managerial “wish list” will not be filled at shareholder’s expense. Only acquisitions that can raise the per-share intrinsic value of Berkshire will be considered.

9) The noble intention of retenting earnings to increase shareholder value will be checked periodically. If they reach a point where retained earnings cannot be used to create extra value, the earnings will be given out to shareholders.

10) Common stock will only be issued when Berkshire can receive as much in business value as they give.

11) Regardless of price, Warren and Charlie have no interest in selling any good business that Berkshire owns. Even for sub-par business, they will be reluctant to sell as long as the business can be expected to generate some cash and they feel good about their managers and labor relations.

12) Warren and Charlie will be candid in their reporting, highlighting both the good and bad. There will not be any accounting maneuvers or restructurings to smooth earnings.

13) Activities in the securities markets will only be discussed to the extent legally required. This is because good investment ideas are rare and any relevation will only serve to invite competition.

Two Added Principles

14) Warren will like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that period. For this to come about, the relationship between intrinsic value and market price will have to be constant.

15) Berkshire’s per-share book value will be regularly compared to the performance of the S&P 500. They expect to outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.

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